When it comes to corporate governance, hedge funds are the new sheriffs in town. That’s the take-away of “Do Activists Turn Bad Bidders into Good Acquirers?” Associate Professor of Finance Nickolay Gantchev and his co-authors reveal new insights about the mergers and acquisitions strategy of firms that shareholder activists target. Among them: activism deters empire-building acquisitions of targeted firms, an often value-destructive force in public companies.
From the end of 2009 to the beginning of 2015, 15 percent of firms in the S&P 500 Index encountered an activist campaign. Around 50 percent had an activist on their share register over the same period.
“In terms of governance, mutual funds, pension funds and unions have ceded their role in actively monitoring firms to hedge funds,” notes Gantchev. Hedge funds, now leading the charge often with activist campaigns, typically own five to 10 percent of their targets, that is, the listed company. “Hedge funds achieve better outcomes and improve the firms they target,” he says. “They are less constrained as investors, have fewer conflicts of interest and better incentives to improve the firm’s performance.”
Empire-building firms are natural targets for activists, according to Gantchev. “Activism and mergers and acquisition (M&A) activity are intertwined,” he says. “A firm’s M&A strategy is one of the reasons they get targeted in the first place. If a company has had low returns from past acquisitions or a high number of recent acquisitions, it’s more likely to be targeted by activists.” This visible, public aspect of the company reveals how management performs.
“Once a firm is targeted by an activist, it tends to have a better M&A strategy.”
Activist investors target firms that over-invest in unproductive acquisitions. The authors studied activist campaigns from 1994-2011 and merger data from 1990 – 2015. They found that some targeted firms had become merger targets themselves. However, those that remained independent exhibited a more disciplined M&A strategy following activism. The study shows that an activism target is about 15 percent less likely to engage in a takeover in the three-to-four years after activism. This lower M&A likelihood is observed especially in cash bids. Gantchev and co-authors say this is consistent with prior research findings: activists frequently demand a reduction in excess cash and an increase in leverage (debt) at their targets, which limits their availability of capital to pursue acquisitions.
Importantly, activists also influence the quality of the deals undertaken. Compared to firms without activist involvement, recent activist targets receive higher announcement returns from the fewer acquisition bids they make after activism. Specifically, these acquirers have three-day announcement returns that are 1.4 percent higher, compared to firms that are not activist targets. Their deals also outperform acquisitions by non-targeted firms by 11 percent over the two years after the announcement, even though they do not pay less for their targets.
“The market believes activity by activists is value-increasing,” Gantchev surmises. “Investors think these acquisitions are better because of the prior engagement of an activist.” The result of better performance years later confirms this positive role of activists.
The study’s results suggest that activists perform an important governance role in the market by disciplining inefficient acquirers. Hedge fund activism lowers the value destruction associated with empire building, and ultimately adds more lasting value for shareholders. Gantchev concludes: “Firms with activist influence tend to buy better firms in the future. Put differently, once a firm is targeted by an activist, it tends to have a better M&A strategy.”